Finding an edge in random markets

AdamAdam Grimes's blogs, General Comments, Trading Lesson, Trading Theory10 Comments

As many of you know from reading my previous posts, one of the tools I use for thinking about markets is to imagine that markets are pure random walks. If this were true, there would be no way to make money trading. Readers often comment that good money management, trailing stops, psychology, etc could help, but the bottom line is if you do not have an edge in the market, you cannot make money. Period. A trailing stop is not an edge in itself (I am aware of the studies in a well-known trading book that show a profitable trading system with random entries and trailing stops. The key is that the markets tested were not random (they were real futures markets), and the exits were not random (they were a good trailing stop system). If markets were random you could not make money trading, and, if you are not convinced of that, you are missing a key piece of the intuition behind understanding price action.

This comment from a reader this morning on an old post is a good chance to dig into the concept a little deeper:

… But it is as simple as this. If you take 10 long trades (let’s keep it at ten for the example) and you enter a random market at 1000. You know that 5 out of ten you reach 990 first and the other 5 you reach 1010 first. What you need to do is to cut your losses of those five that reach 990 at that level. The once that go to 1010 you let them run and you trail them in a way you are comfortable with. And yes, 2 of those 5 that reach 1010 might end up with a loss after all of let’s say 7 and 3. One of those 5 might result in only a win of 7. One might result in a win of 25… But the last one could be that big winner of 60!
So in the end
Total loss: 60
Total profit: 92
Nett profit: 32

Everybody that works with a fixed stop loss AND take profit is doomed to fail. When long you should always get stopped out because prices are coming down and short vice versa. That way your profit is unlimited, your losses are limited and in case you are up your profits are protected.

A useful way to think about this problem is to use something called a binomial tree. Imagine a tree that starts at 1,000 and then goes up or down +/- 10 on the next step, with 50% probability of either step. This pattern repeats as it branches out from the starting point. We might draw it like this:

So, let’s consider the reader’s scenario and break it down into three possibilities:

  1. The first step is down, to our stop of -10. This happens 50% of the time.
  2. The first step is up, to a profit of +10. We do not take profit at this level, but now we “reduce our risk” but raising our stop to 0. The probability of this first step up is 50%.
  • The second step is down, for a loss of 0. This happens with 50% probability from the previous step. The overall probability of this happening is 50% * 50% = 25%.
  • The second step is up, and we book a win of +20. This also has a 25% probability from the beginning.

Remember, our expected value equation for n scenarios is: Expected value = probability of scenario1 * payoff of scenario1 + …. + probability of scenarion * payoff of scenarion. In this case, the math is: (50% * -10) + (25% * 0) + (25% * +20) = -5 + 0 + 5 = 0. Even with the trailing stop, this is a zero expectancy game. In the reader’s comment above he was assuming you could let the winners run, but, in a random market, you will find the probabilities shrink as the profit increases so that the zero expectancy game is maintained. This is an important intuition to build about trading systems and price action. You must have an edge to make money.

I know many of you will protest that if you had more steps in the tree (I simplified so each step was +10) that it would be different. Work it out carefully on paper and you will see that it is not. The message is simple: you cannot create a positive expectancy situation without having some kind of edge, and you cannot have an edge (by definition) in a random market.

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10 Comments on “Finding an edge in random markets”

  1. Excellent post. perhaps a more intuitive way to say it is that if market truly random as described above, with 50% chance at each node, then you would not be able to have an expectancy >0 just like you would not by playing black /red in a 36 number roulette (without the zero).

  2. yes also a good illustration. people get sidetracked in the idea that a trailing stop provides them more control but in a random market it is just like red/black. good point thanks

  3. Adam, great post, I agree 100%.

    However, I would say that many traders who do happen to have an edge with their methodology are still not performing well. As an active trader myself and a trading psychologist I have a second definition of edge. Your edge is your ability to adapt.

    As traders we use logic and data to justify our decisions, and we spend lots of time looking at charts….but at the crucial moment, where the rubber meets the road, it’s our emotions/feelings that actually provide the fuel to pull the trigger or not.

    One’s ability to adapt is critical because set-ups often don’t look neat and clean. Trading involves a lot of disappointment (set-ups not always perfect, target not always reached, we exit and then see it go on to work, etc), and that disappointment often puts traders on tilt where they are unable to follow their plan and break their rules.

    I’m doing a webinar today on this topic where I will introduce ways to deal it.

    Andrew Menaker, PhD

  4. Adam, absolutely agreed that one needs an edge in the market to be profitable. But what I often wonder about is how some edges perisist over a long time – e.g. the turtle momentum system. Would be an interesting topic for a post – imho.


  5. adam dig deeper into math stuff there are people that read this blog mad interested in your methodology and growth vs. seth’s idiocy

  6. You are right, but I want to add something regarding your definition for the edge. You are defining the edge as an ability to adapt. Ok! And let’s say you have adapted from a buy and hold market to a momentum one. But in order to actually make money in the last one, after you adapted, you need to have an edge in the ‘momentum’ market. And that edge is, like Adam put it, the ability to spot the imbalances from the order flow and have a position in the right direction.
    My point is that the edge that you define is a mental one, hence there are many types of edges, but in the end all is reduced to the simple math and the fundamental laws of the market.

  7. Nice post Adam, insisting again on the importance of having an edge!
    Not to be forget that commissions and slippage make trading not to be a zero sum game.

  8. At first I liked this post, but reading it second time I found one fundamental mistake (please correct me if I am wrong). Bassically when you trying to use this example of random entry and random moves up or down as in example to 1010 ir 990 there is big mistake made by calculating possible PL becasue market cannot go up and down at the same time.

  9. If you would move down that mean you move with all ten trades down. and in addition you cannot use same probability if the trades were made in different markets while the market is not the same on which calculation is made

  10. He’s not saying that it goes up and down at the same time. He’s measuring the expected outcome over a large number of trades. If I get into a stock randomly to buy or sell and I risk $10 to make $10, I have an expected outcome of $0. No matter what you do, if you’re risk to reward is equal and you have a 50% chance of success, then you will breakeven (minus fees to your broker). So you win $10 on half your trials, and then lose $10 on the others. No net gain. The only way to make money is that if your risk is ACTUALLY less than your potential gain. This means that you actually have to have something that makes your risk less than your potential gain. This is what is meant by an edge.

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